Value Investing Strategies of Warren Buffett and Benjamin Graham

Archive for the 'Bonds' Category

It has been a while since I last sumarised the annual letters that Warren Buffett writes to his shareholders. I was halfway through the 2001 letter, and will attempt to round it up here.

In that year, Warren Buffett had lukewarm feelings about stocks for the rest of the decade. He felt that the market had outperformed the business for a long period of time, and that had to end. Any investor buying in at that time would likely be disappointed.

Continuing on from Warren Buffett’s discussion on insurance float, we now move on to the most volatile form of insurance, the super-cat (or super-catastrophy) insurance.

Insurance companies and reinsurance companies purchase insurance themselves to limit their losses in the event of a major disaster. A company that is willing to underwrite such policies must have a very strong financial strength.

Berkshire, being in such a position, underwrites super-cats heavily and has a huge involvement in this form of insurance.

When Warren Buffett cannot find a well-run and sensibly-priced business with good economics, he will put his money into very short term instruments. While these investments are likely to result in profits, they could also sometimes lead to losses of substantial size.

On the other hand, an investment into a wonderful business bought at an attraction price WILL always make money. It is only a matter of when.

While Berkshire has done well with negotiated purchases of fixed income securities over the years, their purchases in the secondary market has performed better.

This corresponds with Warren Buffett’s belief that an intelligent investor in common stocks will do better in the secondary market than by buying new issues.

Why is this so?

First of all, the timing of new issues is determined by controlling stockholders and corporations. If the market is unfavorable, they can avoid an offering altogether.

The sellers in a public offering or negotiated transaction are also unlikely to offer a bargain. Most to the time, they are motivated to sell only when they can get a good price.

On the other hand, there are always times in the secondary market whereby mass folly takes place. No matter how low the price may be at that time, you can always find a few buyers who are willing to sell at that price.

Warren Buffett values convertible stocks by looking at three things: interest rates, credit quality and prices (or more precisely, valuation) of the related common stocks.

He warns against inaccurate or misleading valuations by others. For example, several members of the press calculated the value of all their preferreds as equal to that of the common stock into which they are convertible.

By their logic, Warren’s Salomon preferred, convertible into common at $38, would be worth 60% of face value if Salomon common were selling at $22.80.

The problem with using this valuation is that all of the value of a convertible preferred would reside in the conversion privilege and that the value of a non-convertible preferred would be zero, no matter what its coupon or terms for redemption.

This does not make any sense at all.

The correct way of valuing convertible stocks is to firstly look at their fixed-income characteristics. Then, you look at the conversion option and see whether it adds additional value to the basic fixed income valuation.

What this means is that the securities cannot be worth less than the value they would possess as non-convertible preferreds.

What happens if Warren Buffett Dies?

Warren candidly mentions three things that would happen if he passes away suddenly:

“(1) None of my stock would have to be sold; (2) Both a controlling shareholder and a manager with philosophies similar to mine would follow me; and (3) Berkshire’s earnings would increase by $1 million annually, since Charlie would immediately sell our corporate jet, The Indefensible (ignoring my wish that it be buried with me).”

Below investment grade bonds can be divided into two types. The first types are bonds that were initially of investment grade but that were downgraded when the issuers fell on bad times. These are referred to as “fallen angels”.

The second type, “junk bonds”, are those that were already far below investment- grade at the point of issue.

In the past Warren Buffett had bought a few below-investment-grade bonds with success, but those belonged to the “fallen angels” type.

He describes the second type as a mine field, because companies with huge debts would require only a small “business pothole” to turn into a disaster.

In some cases, so much debt was issued that even highly favorable business results could not produce the funds to service it. The interest that they need to pay on their debts was even more than their gross revenue!

Buffett gives an interesting anecdote to explain the difference between a “fallen angel” and a junk bond:

“The universes were of course dissimilar in several vital respects. For openers, the manager of a fallen angel almost invariably yearned to regain investment-grade status and worked toward that goal. The junk-bond operator was usually an entirely different breed. Behaving much as a heroin user might, he devoted his energies not to finding a cure for his debt-ridden condition, but rather to finding another fix. Additionally, the fiduciary sensitivities of the executives managing the typical fallen angel were often, though not always, more finely developed than were those of the junk-bond-issuing financiopath.“

However, while he would never buy new issues of junks bonds, he finds it possible to find good investment ideas in junk bonds that were trading at huge discounts to their issue prices.

Such deals were few and far between, and at the end of the day, it still boils down to three words, “Margin of Safety”.

Buffett had his first Coca-Cola in either 1935 or 1936. In 1936, he started buying Cokes at the rate of six for 25 cents from Buffett & Son, the family grocery store, to sell around the neighborhood for 5 cents each.

While selling the product, he observed the extraordinary consumer attractiveness and commercial possibilities of Coca-Cola.

For the next 52 years, he did not buy a single share of the company, doing so only in the summer of 1988. In the past year, Berkshire’s holdings of Coca-Cola increased from 14,172,500 shares at the end of 1988 to 23,350,000.

Yet another example of the incredible speed with which Buffett responds to investment opportunities. :)

Zero-Coupon Securities

Most bonds require regular payments of interest, usually semi-annually. A zero-coupon bond, conversely, requires no current interest payments. Instead, the investor receives his yield by purchasing the security at a significant discount from the final maturity value.

The effective interest rate is then determined by the original issue price, the maturity value, and the amount of time between issuance and maturity.

For example, Berkshire issued some zero-coupon bonds at 44.314% of maturity value (due in 15 years). For investors purchasing the bonds, that is the mathematical equivalent of a 5.5% current payment compounded semi-annually.

The point about zero-coupon bonds is that the issuers do not need to pay any interest on their loans. This offers one advantage: It is impossible to default on a promise to pay nothing – until maturity date.

That also means that the time elapsing between folly and failure can be stretched out.

The warning sign for mischief-making should go to the zero-coupon issuer unable to make its interest payments on a current basis.

Whenever someone creates a capital structure that does not allow all interest, both payable and accrued, to be comfortably met out of current cash flow net of ample capital expenditure, be extra careful!

Some CEOs clearly do not belong in their jobs; yet their positions are usually quite secure. The irony is that it is easier for an inadequte CEO to keep than it is for an inadequate subordinate.

If a secretary is hired for a job that requires typing ability of at least 80 words a minute and turns out to be capable of only 50 words a minute, she will lose her job in no time. Similarly for sales people that fail to meet their quota.

However, a CEO who doesn’t perform frequently stays on in his role, at least for some time. One reason is that performance standards for his job seldom exist. When they exists, they are usually fuzzy and any shortfall is usually waived or explained away.

At many companies, the bullseye is painted around the spot where the arrow lands.

Another important, but seldom recognized, distinction between the boss and the foot soldier is that the CEO has no immediate superior whose performance is itself getting measured.

It is in the immediate self-interest of a manager to weed out any under- performers in his team. But the CEO’s boss is a Board of Directors that seldom measures itself and is infrequently held to account for substandard corporate performance.

Bearing the above points, they should not be interpreted as a blanket condemnation of CEOs or Boards of Directors: Most are able and hard- working, and a number are truly outstanding.

Holding Period of Securities

When Buffett own portions of outstanding businesses with outstanding managements, his favorite holding period is forever. This is just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint.

Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.

Long Term Bonds

Buffett continues to hold his aversion towards long-term bonds. That will change only if prospects for long-term stability in the purchasing power of money improves. And that kind of stability is unlikely: Both society and elected officials simply have too many higher-ranking priorities that conflict with purchasing-power stability.

Arbitrage

The word abitrage used to mean the simultaneous purchase and sale of securities or foreign exchange in two different markets. The goal was to exploit tiny price differentials that might exist between, say, Royal Dutch stock trading in guilders in Amsterdam, pounds in London, and dollars in New York.

Since World War I the definition of arbitrage – or “risk arbitrage”, has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender, etc. In most cases the arbitrageur expects to profit regardless of the behavior of the stock market.

The major risk he usually faces instead is that the announced event won’t happen.

To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire – a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

Berkshire’s arbitrage activities differ from those of many arbitrageurs. First, they participate in only a few, and usually very large, transactions each year. Most practitioners buy into a great many deals perhaps 50 or more per year. Warren Buffett certainly does not want to spend all his time monitoring the progress of so many deals and the market movement of the related stocks!

The other way is that they participate only in transactions that have been publicly announced. No trading on rumors or trying to guess takeover candidates.

Efficient Market Theory (EMT)

The EMT said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices.

While they observed correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient.

In Buffett’s opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp, Buffett Partnership and Berkshire illustrates just how foolish EMT is. Returns have averaged 20% per year compared to the average market returns of 10% per year. That is a significant statistical difference.

All this said, a warning is appropriate. Arbitrage is not a form of investing that guarantees profits of 20% a year or, for that matter, profits of any kind. As noted, the market is reasonably efficient much of the time: For every arbitrage opportunity that Buffet seized in that 63-year period, many more were foregone because they seemed properly-priced.

An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline. Investing in arbitrage situations, per se, is no better a strategy than selecting a portfolio by throwing darts.

Listing of Berkshire

Berkshire’s shares were listed on the New York Stock Exchange on November 29, 1988. Berkshire’s goals differ somewhat from most other listed companies.

First, they do not want to maximize the price at which Berkshire shares trade. Rather, they wish for them to trade in a narrow range centered at intrinsic business value.

Significant overvaluation as significant undervaluation will inevitably produce results for many shareholders that will differ sharply from Berkshire’s business
results.

If the stock price instead consistently mirrors business value, each shareholder will receive an investment result that roughly parallels the business results of Berkshire during his holding period.

Second, they wish for very little trading activity. Their goal is to attract long- term owners who, at the time of purchase, have no timetable or price target for sale but plan instead to stay with them indefinitely.

Lots of stock activity can be achieved only if many of the owners are constantly exiting. At what other organization – school, club, church, etc. – do leaders cheer when members leave?

Of course, some Berkshire owners will need or want to sell from time to time, and there needs to exists good replacements who will pay them a fair price. Therefore they will try to attract new shareholders who understand their operations and share their time horizons.

If they can continue to attract this sort of shareholder – and, just as important, can continue to be uninteresting to those with short-term or unrealistic expectations – Berkshire shares should consistently sell at prices reasonably related to business value.

He has no particular bias when it comes to choosing from these categories. The aim is to achieve for the highest after-tax returns as measured by “mathematical expectation,” limiting himself always to investment alternatives that he can understand. His criteria have nothing to do with maximizing immediately reportable earnings; rather, is to maximize eventual net worth.

Common Stocks

In 1987, Mr Market was on a major rampage until Oct, when it had a sudden seizure. The net result was a gain of 2.3% for the Dow.

Many prestigious money managers now focus on what they expect other money managers to do in the days ahead, rather than on what the business will do. An extreme example of what their attitude leads to is “portfolio insurance”, where a downtick of a given magnitude automatically produces a huge sell order.

Considering that huge sums are controlled by managers following such practices, is it any surprise that markets sometimes behave in illogical fashion?

After buying a farm, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighboring property was sold at a lower price?

Such markets are ideal for any investor – small or large – so long as he sticks to his investment knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.Mr. Market will offer us opportunities – you can be sure of that – and, when he does, we will be willing and able to participate.

Bonds

Warren continues to parking most of his money in medium-term tax-exempt bonds, with an aversion to long-term bonds. Even back in 1986, he is already not optimistic about the long term future of U.S. currency due to the enormous trade deficit.

The pileup of “claim checks” in the hands of foreigners will ultimately lead to an increased pressure on the issuer to dilute their value by inflating the currency.

While recognizing the possibility that he may be wrong and that present interest rates may adequately compensate for the inflationary risk, Warren retains a general fear of long-term bonds.

Market Rumours

It is often reported in the press about Berkshire’s purchase or sale of various securities. Warren does not comment in any way on rumors, whether they are true or false. If he were to deny the incorrect reports and refuse comment on the correct ones, he would in effect be commenting on all.

His advice for anyone who wants to participate in whatever Berkshire is doing, is to simply buy the Berkshire stock!

About Debt

It is likely that Berkshire could improve its return on equity by moving to a much higher, though still conventional, debt-to-business-value ratio. It’s even more likely that we could handle such a ratio, without problems.

However, “likely” is not good enough for Warren. He wishes to be “certain”. Thus he adheres to policies – both in regard to debt and all other matters – that will allow them to achieve acceptable long-term results under extraordinarily adverse conditions, rather than optimal results under a normal range of conditions.

Good business or investment decisions will eventually lead to economic gains, even without the use of excessive leverage. However, he is willing to borrow as long as the amount does not pose a threat to Berkshire’s well being.

His strategy is to finance in anticipation of need rather than in reaction to it. A business obtains the best financial results possible by managing both sides of its balance sheet well. This means obtaining the highest-possible return on assets and the lowest-possible cost on liabilities.

It is often that opportunities for intelligent action on both fronts do not coincide. Tight money conditions, which translate into high costs for liabilities, will create the best opportunities for acquisitions, and cheap money will cause assets to be bid to the sky. Therefore, his action on the liability side should sometimes be taken independent of any action on the asset side.

This fund-first, buy-or-expand-later policy almost always penalizes near-term earnings. For example, Berkshire is now earning about 6.5% on the $250 million they recently raised at 10%, a disparity that is currently costing them about $160,000 per week.